Ep. 38: How Will This Play Out in Real Estate

President of Prospera Growth Fund, Kellen Jones, talks about the strengths of real estate as a tangible asset against the market and market volatility.

Thomas Young:

Hi, everyone. Welcome back to Rocket Your Dollar. Today, I'm stoked to have Kellen Jones with me. Kellen is the president of Prospera and founder of the software and deal flow organization that now contributes to Prospera's prominence. Jones is known in part for pioneering higher quality underwriting and credit models for private lenders and investors. His expertise has been utilized nationally by real estate firms in nearly every asset class, namely student housing, senior and assisted living, multifamily, investment-purpose SFRs, so think your fix-and-flips, office, retail, recreational, agriculture, ground-up development, and others. Jones serves on the American Association of Private Lenders Ethics Board and has become an established speaker instructor and panelist. With over 15 years of real estate finance experience, Jones has been instrumental originating and funding over $750 million in transactional volume.

Kellen, thanks so much for being here today. I know that was a little bit of a mouthful, what I read, but I'd love for you to give us a quick intro and tell us a little bit about what Prospera does before we jump in.

Kellen Jones:

Well, I appreciate the opportunity and I thank you again for having us. In a very similar market to what we're experiencing right now, we established our initial fund. We had been lending as a syndicator for two or three years leading up to the 2008 crisis. Appraisers were, in our humble opinion, starting to overvalue property. We had a lot of mortgage clients who were looking at these 1% option arms and 125% cash-out refinances and we were saying, "Look, if you're borrowing money from an overvalued property, not only are you borrowing that money, but there's going to be a day where you have to pay it back and that may come sooner than later if those values are that far off."

All of a sudden at the very moment when banks stopped lending money, we had so many people asking us, "Okay, well, how do I create arbitrage now that I've got this money?" that we established our first fund and started lending much more programmatically. Our initial fund is now just over 12 years old. Its primary product is a bridge loan. We range typically from a million to $10 million on our bridge loans, a secured and senior position by commercial real estate. We do have a single-family component. The loans are smaller. On the investment side, we try to diversify by asset type, asset size, and location so that when things like what we're experiencing right now occur, we're not "all on black," as they say.

Along the way, we also realized that in addition to a rinse-and-repeat kind of 1% average monthly target through our income model, through our lending fund, that many of our investors desired for a growth opportunity and we were seeing so much deal flow through our software platform and just from being performers in the lending space that we also created a growth product that's centralized on seven or eight developments at this point. It's a smaller portfolio by deal quantity, but much larger because the deal sizes are larger and more deliberate because we are partnering with real estate investors or developing assets ourselves.

Along the way, we started addressing one pain point at a time as we determined that there weren't any software options that could help us manage our investors and send statements and allow someone to do due diligence on our fund or service our loans in the same place or cut term sheets or manage assets, all these pain points that we experienced. We ran our companies over the shoulder of great developers for several years until we had an amazing platform and we now have what I feel like is one of the most robust and comprehensive options on the fintech side for our industry specifically as well.

It's been a great ride. My favorite part of being involved in this part of the economy is that you're taking folks' capital that they have either worked a lifetime to accumulate or maybe brought in through inheritance of some sort, but no matter what, that capital was made somehow and entrusted with us and we take it and do things that maybe banks or are less likely to do and that typically arms a real estate investor to build something tangible, whether it's an office building or a multifamily property, either businesses will thrive there or families will make memories there. It's really exciting to see that that link from capital that comes into the fund to going out into the economy. Then it all trickles back in form of dividends to our investors.

Thomas Young:

Yeah, that's fantastic. The fact that when you guys started, we were at the height of the real estate boom in the mid-2000s, and then you guys rode out 2008, 2009, 2010. As we all know, those circumstances, while devastating, can also create opportunities for a lot of people if you're in the right position to take advantage of it. I don't mean take advantage of people, but take advantage of situations and play to uncertainty and things that we don't really know about.

As we record this, it's April 21st and we're amidst a global pandemic, which is going to have repercussions far beyond what we know of. As painful as it is for a lot of people and it's also going to create different opportunities for people, I think, outside of the stock market. I mean, what we've seen in the last few months is just this level of volatility that I think a lot of people when this is over, are going to go, "I don't want to be on this rollercoaster anymore," and they're going to start looking at different asset classes such as real estate, such as lending. It's really, I think, going to boost even more than what it was before. I mean, that real estate has been hot for 10 years if not longer, but I think we're going to see the second wave of interest.

I'm curious, where do you think that we're going to go? I mean, there's a lot of talk about a lot of companies going virtual, a lot of telecommuting. I mean, where do you sort of see this playing out in the next six to 12 months on the commercial real estate? Then we can talk about residential after that.

Kellen Jones:

I guess regardless of what happens, then we can talk about that, that is the beauty of the commercial real estate. At its core, it's tangible. It's an asset that... God isn't creating any more Earth and once an asset is developed and built, you might repurpose it, you might demolish it and rebuild it after years and years, but it's a tangible asset and that is the biggest factor in my mind between the strengths and the quality of our asset class when compared to the market.

Regardless of the performance, regardless of the volatility, regardless of whatever happens, as our investors call and say, "Well, great quarter, but what are you expecting this year?" they're typically asking about performance and I try to say, "Look, the thing that makes me sleep at night is if all borrowers and all tenants stop making their payments and there isn't enough of our portfolio performing as it traditionally has to hit that yield target that you've come so used to."

We're a principle-preservation product and unlike so many of the market products that say, "Look, because the buzz isn't here because corporate profits are down, this stock is now in the tank," and there's no explanation. It has no connection to EBITDA. There isn't a tangible asset under it, not that people and products are not tangible, but in commercial real estate, worst case, Armageddon isn't even upon us yet and something even worse happens and maybe we go from recessive-type behavior in the economy to a depression, if all we do is hold are our core assets.

I think history will at least repeat itself in this one way, whether it's 10 months or 10 years. That asset will be worth more than it is today, so there might be a small valuation, a correction because of the economics that feeds those values and cap rates and such, but at its core, commercial real estate is an asset class that we love because it's more reliable because it is something you can touch and feel and see.

As I look at the various dynamics, I was a little bit impressed that there weren't as many defaults right out of the gates as were thought to maybe occurring this first month out of the gates. That probably should be the way that it is because obviously, whether you're a private lender or you're a bank, you're underwriting the borrower's ability to pay their payment, often without the property performing. You're saying, "Okay, I need six months' principal interest, taxes, and insurance in an account that we control or an interest reserve that's funded for a certain time or the event of default."

There should be a loan mechanism or an underwriting mechanism that protects most borrowers and lenders from one month of bad economics leading to defaults. That might not be the case if this continues for five or six months, although I do think there have been several businesses that have learned, "Well, hey, instead of a million dollars every quarter on soda machines and culture and commercial space, let's repurpose those dollars into comfy home office chairs and rethink the way that we're meeting."

Frankly, I believe there's always a place for human interaction to where if there was the ability to create a hybrid where people have more autonomy to be productive remotely, but what we don't get right now is that the standup meeting once a week or a staff meeting from time to time, I don't think that's ever going anywhere anytime soon, but I do feel like this has taught us a lot about what we can do remotely and that could impact commercial real estate in the meantime, but just like we saw with big box and now you're seeing some repurposing going, the big boxes lose some business to Amazon, but the landlord turns around and rents that space as a shipping warehouse for Amazon. I think there will be a lot of that and hopefully, it's short-lived as far as the impact on everyday Americans and businesses alike.

Thomas Young:

Right. You said something that I thought was interesting because, yeah, if you're a month or two months into whatever crisis may be and you're unable to service your loan or pay your rent or whatever, as a commercial tenant, especially, you're living a little too close to the edge where then you probably have some other issues going on, but that would make up a small minority.

Then if this plays out for a lot longer, the other thing that I love that you said is that your investors are calling you asking about performance when most people are calling their brokers or they're looking at their bank card portfolio going, "Oh, my gosh." The fact that people are just still worried about performance in your case is comforting. That's a good thing.

Kellen Jones:

Well, on both of those points, the first thing, in regards to preparation, although many businesses including many lending funds and other types of investment products, especially the way we're... I mean, one of our funds is structured to where we don't charge a front or backend sales fee. From the beginning, we've said, "Look, we want to be aligned with our investors to where there isn't this idea that even if we don't do well, we eat."

We structured our primary fund and it's still structured that way today to where all the funds go into one kitty, whether it's origination fees, interest earnings, tenant payments, sales disposition proceeds, it all goes into the general income of the fund and the investors take a split and we take a split. We're aligned to always be cranking and we only make money when the investors do, so in an environment like that, we do thrive on performance. We want to perform so that we can continue to operate. We have our other offering that does have a different fee structure so that the lights can stay on even if there isn't a performance on those growth-oriented deals.

Although there are such small margins in so many American businesses and you know you're talking one-and-a-half months, maybe and businesses aren't prepared, with all due respect, it's not like we didn't have fair warning. I mean, we've been late cycle. That term has been used for three or four years at conferences and papers and there's been a massive amount of research about how long in the tooth we have been since the recession and climb since 2008. We've been preparing for this for a long time.

On the latter point in regards to comparing it to the market, our asset class, because you have so many ways of creating income and value, you have dividend income and you have appreciation value, and whether you get both at the same time or one or the other in an economy like this, you got one or the other at least then you compare it to... I looked at the market. In 2016, 2017, you have most people saying, "Look, this is amazing. The market is the best place to be."

The volatility that we've historically seen has gone and at the end of 2017, it's up 20% over 2016, and then by the end of 2017, it's down from that 20% high at the end of 2016 by about 7%. Then you see it up another 19% from that point in 2018. In 2019, you see a pretty good year. If you look at what a million dollars would do in the market, on February 12th, when the market had its highest day ever, basically, if you had invested $700,000 day one, January 1st, 2016 on February 12th, 2020, you have $960,000. You're up if you're comparing to S&P or the Dow to 960. Literally, by March 16th, you would have $507,000 in your capital account. From the high to that point, so not at 47% drop from zero, but from the high, you would have lost 47% of that account balance and then another 10% by March 23rd.

Now, it's rebounded a little bit and fallen and going back and forth and that's the trouble with the market is people that are long on the market say, "Well, it'll come back," and it will, but are those gains ever gains if you never take any chips off the table? In real estate funds, even if the performance moves a little bit, at least you know the appreciation is always occurring in the background.

Thomas Young:

Right, and the fact that being paid a dividend or the rental income to whatever kind of real estate you're in is taking chips off the table that can then be used for other things, right, for investments in the market or wherever you want, but yeah, I like that, too, a lot about real estate, that it's just you've got both sides, we've got the cash flow/revenue-generating side and then the appreciation is super important.

I'm curious, who are your investors at Prospera? Is it institutional? Is it individuals? Is it high net worth folks? Who makes your investor base?

Kellen Jones:

Yeah, both of our primary funds are Reg D 506(c)s. We didn't always operate as a Reg D 506(c) in our initial offering because that wasn't a designation available to us until the Jobs Act passed. It passed, we could then generally solicit and bring in regular accredited investors, or at least tell regular accredited investors about how great our products are.

We have a couple of hundred high net worth individuals, many of which are folks that find us through registered investment advisors. We are on three of the primary platforms that RAs are able to allocate to a major quadrant of our investor base invest through their self-directed IRAs, 401(k)s with custodians, and good folks helping them through that like you all. We've avoided any institutional capital and especially leverage. It's the decision we made very early. Our returns through our models seem to be good enough that we don't need to juice the IRR with leverage.

As hard as I've hammered the market a little bit, although I think there's a good place in every portfolio for the market, if I'm comparing to other folks in our industry, the error that they sometimes make is too much leverage or institutional capital. We see in a market as we have just experienced that if you are beholden to the same dynamics of the capital markets that the market is, then obviously, the same type of dynamics that cause regular retail investors to come up with margin calls when the market turns, those are the same things that dry your capital up if you rely on those types of capital sources. We like to align with high net worth individuals that invest anywhere from a hundred thousand dollars to several million dollars. We seem to have a great fit with those folks.

Thomas Young:

No, that's fantastic. I love what you touched on leverage, about not using it just to boost those internal numbers. Just because when the market turns and you're in a situation like you are today, I mean, you guys can ride this out that a lot of firms won't because of those capital calls. You guys could shut it down and just hold everything, almost indefinitely, I mean, as long as your investors will tolerate it, but it seems to me like they would just because there's really nowhere else to go right now, and then be able to generate returns again and not just basically lose your portfolio because you're over-leveraged.

Kellen Jones:

Yeah. If I could make one point on that, you look at traded REITs and they're not even valued by the real estate and the portfolio, but more so by the value of the stock. You look at non-traded REITs and they are so highly leveraged typically that there's someone else calling for capital and they don't necessarily have any other option than to lock up all their investors and hope to get as much as possible. If they have to take it short, then their investors take a loss and they're forced to sell off just to pay off their debts and their investors come second.

To be a senior position lender or the developer or owner of these core assets without a degree of leverage, it is the thing that makes it so that although you know our investors call and say, "I just read this thing about non-traded REITs and because you have your rate designation and one of the funds, is this you?" and I have to remind them that we don't play by the same rules as most non-traded REITs in that they are so highly leveraged.

Then so many players have come into our space since the Jobs Act passed. It's been a very healthy improvement to our industry and it's brought a lot of innovation. It's made it possible to democratize how investors can access our asset class and be part of it, be part of a loan, or a project that otherwise they'd never be able to be part of because the institution gobbles it up. However, many of those groups are not familiar with what it takes to manage a portfolio as it becomes mature or as loans default and those challenges ensue and they don't have the luxury to learn because of the way that they capitalize themselves is through leverage as well. I appreciate your observation of how critical that is and how it can be the determining factor in, really, your fate through a market like this.

Thomas Young:

Right, yeah. I've been reading several things that, I mean, if you wanted to be a real estate investor, starting in 2011 to now, you've lived in a pretty comfortable world, especially in... I live in Austin, Texas, where if you could afford real estate 10 years ago, you've made stupid amounts of money, but now is when it gets a little bit trickier. There's a little bit more... This is where experience comes in and folks that have been doing it for a couple of market cycles are going to... You're going to separate the men from the boys a little bit because that experience is just so valuable, you can't put a price tag on it.

It'll be really interesting to see how the real estate market plays out, how residential plays out, especially with 20-something-million people unemployed, unable to pay their rent. Foreclosures on multifamily properties are going to start probably going up because the people are over-leveraged and they can't afford the payment, right? Even small investors might not be able to afford their rent payment or their mortgage payment because their tenants aren't paying. I mean, it's going to be interesting to see what happens.

I'm curious to get your thoughts on that. What do you think is going to happen to individual real estate investors that are maybe multifamily or smaller commercial or individual investors?

Kellen Jones:

There was so much temptation to buy so many of the dips that even the smartest commercial real estate investors and fix-and-flip investors looked at the market and said, "Oh, my goodness. Maybe that's where I need to be right now because it's low and I've got a little liquidity and the future is uncertain for real estate." I think that that was a momentary temptation and that most of the serious commercial investors and high-volume residential investors are staying the course to some extent. Much of what they can do and will continue to try to do comes down to how they're capitalized. Just like we were talking about for lenders and how they have capitalized and what capital markets strings they have above them, the other side of that is how your investors are capitalized.

For our borrowers, for instance, if an interest reserve is depleted and a borrower's debt service coverage disappears, banks and non-bank lenders have the ability, especially with federal help, to go to those real estate investors, those borrowers, those equity partners say, "Look, this is an impact on all of us. We have only a few options. We can start the foreclosure process and argue about your default or we can work with you." In many cases, that's going to have to be some sort of modification to keep the fuel behind investors that are otherwise not able to stay active and make their payments eventually.

In our case, more often it is not just a modification, but a relief valve where we say, "Look, our mandate is to protect our investors. No matter what, our goal is to maintain a principle value and hopefully income associated with this project." Every decision we make has to maintain our position or improve our position.

You don't want a big negative event that disrupts your ability to move forward after this all passes, we don't want to downgrade our position, so you talk about things like deeds in lieu, where you take a deed in lieu of foreclosure. Now, the fund holds that asset and has the primary collateral in its portfolio without any more rigmarole to get to that asset if the borrower were to default under different circumstances. We do a deal with the borrower where they stay in place, we pay them as a manager and ultimately, when the economy turns, we sell and we have an agreement to where they take a portion of that. In the meantime, they don't have to service the debt and we've maintained reserves to keep property taxes paid and improve that asset or stabilize it as needed.

I think that banks and lenders are going to have to be open to those sorts of workouts. Investors are going to have to be very clear and communicate often about what they are experiencing to get the best result. I think that those who saved a little liquidity on the sidelines or took chips at the right time so they could wait for this very type of a fall, they'll do as the Warren Buffetts and the Ray Dalios of the world suggest and take advantage of the opportunities that help other people but help them grow wealth.

Thomas Young:

Yeah. I agree with what you said. It just seems to me that right now, because we are in such uncharted times and territory, flexibility and clarity become just the name of the game. The more flexible you can be as a lender, as a borrower, as a contractor, whatever sort of role you fill, being able to be flexible and work out terms with the people that you work with is going to be super important.

Then to your second point, people that prepared are going to be in a good position to do well. It'll play out the way it's going to play out, hopefully, right, and then sooner rather than later, we can return to some shred of normalcy, but at the same time, it'll open up opportunities and it'll allow for new investors that were maybe sitting on the sidelines waiting for... I don't think anybody could have imagined what we're living through right now exactly, but some event that took a little bit of the froth off and allows them to enter the market. It'll be interesting to see it play out, for sure.

Kellen Jones:

It will.

Thomas Young:

Kellen, if anybody that's listening wants to get in touch with someone at Prospera or with you, what's the best way to learn more about what you guys are offering some of your investment options or just to have a conversation with you or someone on your team? What would be the best way for them to go about it?

Kellen Jones:

There are several channels. Prospera.fund is the easiest way to get in that queue. For your audience, our best intake email is invest@prospera.fund. If I can, so often when I speak, it seems like everyone, especially accredited investors have an IRA or a 401(k) that is just sitting in a bad product.

Speaking of Ray Dalio and Tony Robbins, I heard the discussion between them once about how the investing public invests. 95% of our investing public does, so through one of those vehicles and 95% of those are invested in, typically, mutual funds. If you look at mutual funds exclusively, not as a diversification tool, but as an exclusive portfolio piece for a self-directed IRA or 401(k) investment, especially when you factor in all the fees that those folks never really see, there aren't 10 years in history if you run it versus another type of managed portfolio that the mutual fund portfolio will win.

When I'm in Vegas speaking, I equate it to blackjack. If you're looking at the dealer showing a 14 and you are showing a 20 you're not going to take the card because it's most likely going to bust and she has the most likely bust hand. It's an 8% chance that you're going to improve your hand. With mutual funds exclusively over 10 years, you have a 4% chance of any gains.

It's so refreshing to speak to folks who have an eye on those who have these funds sitting idle or in a portfolio that is traditional without any thought or understanding that they can direct that into a product like ours because it is the difference between riding this rollercoaster and then if you're like my father-in-law, in the last three years of your career when an average is determined by the last three years of your portfolio during your career and you have a down year like this, it's unfair.

In the meantime, it's really important for folks to maintain some semblance of income and growth without so much volatility and correlation to the market, so I appreciate what you're doing. If folks want to utilize us as part of their strategy, that's primarily how they get in touch with us.

Thomas Young:

Oh, fantastic. Yeah, I love what you said. I mean, I was talking to a friend of mine on the phone and she's getting near to retirement. She was planning on retiring this month and just always had, I think, I don't know, Schwab or Fidelity IRA or something like that. She goes, "No, I think I've got to work a couple more years just because I don't have..." It's just a bad situation, right?

That's what we preach at Rocket Dollar is it's just putting all your eggs in one basket. Even though they may sell you that basket as diversified, it's not. There are just so many different investment opportunities and there are so many asset classes that are much more exciting, much more products out there. We just want to have our small part in letting people access those with folks like you.

I appreciate what you guys do. I'd be curious to speak with you guys in the next few months and just check in on how everything's going, but for now, thank you, Kellen, so much for taking the time out of your day to talk to us and share your expertise. I'm sure we'll have you back on very soon.